inventory turns by industry

inventory turns by industry

The Benchmark for Inventory Turns in the Wood Industry

How long inventory stays on hand can determine profitability of a lumber company.

Lumber companies use ratios to analyze many aspects of their performance. Managers, shareholders and creditors use them to analyze the liquidity, solvency and profitability of a company. Ratios dealing with inventory are particularly important. If a lumber company doesn't have enough wood on hand, it will not be able to fill orders; if it has too much wood on hand, it will cost the company money to store it.

Calculating Inventory-Turnover Ratio

One of the components of the inventory-turnover ratio is the cost of goods sold. The cost of goods sold is what the company paid for the material it sold. The inventory-turnover ratio is calculated by dividing the cost of goods sold for a time period by the average inventory value in that time period. If the time period is one year, you would divide the cost of goods sold for the year by the average amount of inventory for that year. For example, if a lumber company had cost of goods sold of $50,000 for the year, and the average inventory amount was was $10,000, the inventory-turnover ratio would be 5 ($50,000/$10,000 = 5).

Another ratio is called the inventory-period ratio, which reflects the average number of days' worth of inventory on hand. This ratio is calculated by dividing 365 by the inventory-turnover ratio. For example, if the inventory-turnover ratio were 5, the inventory period would be 73 (365/5 = 73). This would mean the company kept enough wood on hand to last 73 days. Due to different industries having different inventory requirements, it is important to compare the inventory-turnover ratio of a lumber company with others in the same industry.

The average inventory turnover in the lumber industry is 10. This means that on average, a lumber company has enough inventory on hand to last about 36 days (365/10 = 36.5). Keep in mind that this number is an average, and it will vary depending on the size of the company and its location.

The inventory-turnover ratio should be compared with those of other companies in the same industry, as well as with inventory turnover of the same company in prior years. However, it is not the only industry benchmark that should be analyzed. Another ratio to use is net profit margin, which is calculated by dividing net income by net sales. The average net profit margin in the timber industry is 7.6 percent. This means that for every $100 in revenue a timber company earns, its average profit is $7.60. Comparing the inventory period and net profit of a lumber company with others in the industry will give you an idea of how well that company is performing.

Shane Blanchard began writing in early 2010 and has tutored students in accounting, business finance and microeconomics. He graduated from the University of North Carolina, Charlotte with a Bachelor of Science in accounting. Prior to graduating from UNC, he graduated from Mitchell Community College with an Associate of Applied Science in business administration. Blanchard is a licensed property and casualty insurance agent.

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. This measures how many times average inventory is “turned” or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. A company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over.

This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs.

The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That’s why the purchasing and sales departments must be in tune with each other.

The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.

Average inventory is used instead of ending inventory because many companies’ merchandise fluctuates greatly throughout the year. For instance, a company might purchase a large quantity of merchandise January 1 and sell that for the rest of the year. By December almost the entire inventory is sold and the ending balance does not accurately reflect the company’s actual inventory during the year. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two.

The cost of goods sold is reported on the income statement.

Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys.

This measurement also shows investors how liquid a company’s inventory is. Think about it. Inventory is one of the biggest assets a retailer reports on its balance sheet. If this inventory can’t be sold, it is worthless to the company. This measurement shows how easily a company can turn its inventory into cash.

Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks want to know that this inventory will be easy to sell.

Inventory turns vary with industry. For instance, the apparel industry will have higher turns than the exotic car industry.

Donny’s Furniture Company sells industrial furniture for office buildings. During the current year, Donny reported cost of goods sold on its income statement of $1,000,000. Donny’s beginning inventory was $3,000,000 and its ending inventory was $4,000,000. Donny’s turnover is calculated like this:

As you can see, Donny’s turnover is .29. This means that Donny only sold roughly a third of its inventory during the year. It also implies that it would take Donny approximately 3 years to sell his entire inventory or complete one turn. In other words, Danny does not have very good inventory control.

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The Benchmark for Inventory Turns in the Wood Industry

Lumber companies use ratios to analyze many aspects of their performance. Managers, shareholders and creditors use them to analyze the liquidity, solvency and profitability of a company.

Inventory turnover ratio & industry analysis tool | BDC.ca

This tool will calculate your business' inventory turnover ratio and compare the results to your industry's benchmark.

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After a recent seminar, a participant reached out to me about his company’s inventory turn rate. After learning how to properly calculate the formula, he realized that his company had been overstating its turns for a long time and were lulled into a state of complacency. When he looked at the real turn numbers, the results were less than stellar. They were of great enough concern that he felt his employment might be in jeopardy if a plan for improvement was not developed. Fortunately,

creating a plan is easy. Execution may be another story.

Like many companies, this one was a victim of misinformation and comparison. I have always been skeptical of industry benchmarks when it comes to inventory

turns. Not that the method of information gathering is flawed, rather the method of calculation by the reporting companies can vary greatly. Here is the proper equation:

Annual Cost of Goods Sold from Stock Sales

Average Inventory Value

Many companies overstate their inventory turns by inflating the

numerator in the equation – annual cost of goods sold from stock sales.

They do this by including all sales. This may include direct-ship or non-stock sales. Remember, when we are studying inventory turns, we are trying to determine how well the inventory we have invested in is performing. The faster we turn inventory, the more times we are able to collect the gross margin associated with the product. When we perform a direct-ship transaction, we are not using stocking inventory carried in our warehouse. We are relying on the supplier’s inventory investment. This is why these transactions should be excluded from the calculation. In a similar vein, a special order of non-stock product does not rely on our stock inventory. Because we did not carry the product in our warehouse, it should not be part of our turns calculation. Both types of transactions are good for distributors, they just don’t need to be included in

measuring inventory performance.

When trying to improve turns, we can attack the numerator of the equation (sell more stuff) or we can attack the denominator of the equation (stock less stuff). When working with distributors on this decision, I generally ask, “Where is the control?” Although we have some control over the numerator (sell more stuff), the customer generally dictates how much product they can consume. When we look at the denominator (stock less stuff), the discretion rests solely in the hands of the stocking distributor. Because we have ultimate control, the denominator is where distributors can make the greatest improvement in inventory turns.

As many of you know, I tend to rely heavily on a reporting tool called the hits report. It is my go-to tool for a majority of my inventory consulting engagements. As a quick reminder, the hits report analyzes the number of times an SKU appears on a sales order in a calendar year. Quantity sold is not relevant to this analysis. In this report, I generally want to see these columns:

  1. SKU
  2. Quantity on hand
  3. Unit cost
  4. Current on hand investment
  5. Hits
  6. Average monthly usage
  7. Months of inventory on hand

Some distributors have found it useful to add an item description column and package quantity column. The report should be run by location for our purposes. There are benefits to a company-wide report, but not for improving turns. From this simple inventory movement analysis report, we can formulate a plan of attack designed to reduce the average inventory value without jeopardizing customer service level.

With this client, my first suggestion was to rank the report by the number of hits in descending order. His first task was to segregate any item with less than four annual hits. These items are clearly not the favorites of your customer base. Since your customers don’t seem to be supporting them with their wallets, should we be carrying

them with our wallets?

The simplest answer would be to convert all these items to non-stock status. This doesn’t mean that we can’t sell them. These items would just be sourced rather than stocked. Since they are so infrequently purchased, the additional time spent on sourcing should be minimal. Before we get out the broad sword and kill all of these items, we need to identify a few potential exceptions. Some items might be part of a greater whole. I tend to view repair parts in this manner. Keeping a few on hand is probably a good idea. You may have a contractual obligation with a customer. Just make sure it is one that pays you on a regular basis. You may have an obnoxiously high gross margin on the item when it is sold. As long as you don’t break it in the several months it sits on the shelf before you sell it, I can live with this one. All others should be converted to non-stock. Let the liquidation proceedings begin.

My next suggestion with this client was to look at the surplus inventory from the last column of the hits report. I asked him to rank the remaining items, after moving the slow and dead to non-stock status, by months of inventory on hand. The next step is to isolate the SKUs with several months of inventory on hand. I generally isolate anything with more than eight or nine months of inventory on hand. This is the first shot. I can dig deeper, meaning six or seven months on hand, if I don’t have enough targets. For most distributors, nine months is a good start.

Take this newly isolated group and re-rank the items by current on-hand-invested in descending order. Start looking at the big dollars. Why do I have this much on hand? Is it because of a manufacturer package size? Did I buy at a higher quantity to get a lower price? Are my buyers using gut feel versus the inventory replenishment system we paid for? Is there a bad min or max number in the system? Do some research and find out what is causing the inflation. Take appropriate corrective action.

In order to set a goal for yourself, take a snapshot of the slow and the dead items. How much money do you have sitting idle? If you reduced your average inventory value by this amount, what would your inventory turns be? This is a good first goal.

Determining the surplus dollars is a bit more challenging depending on your software. First, you would need to know the maximum quantity on hand, for any given SKU, for optimal replenishment. Then you would subtract this from the current dollars on hand. This may be more analysis than you are ready to handle. If you are able to determine an amount of dollars in surplus, subtract this from the new average inventory value. Re-run the turns calculation and see where it takes you.

If the spread between your current inventory turns and your first goal is greater than one full turn, don’t expect to hit your goal in the first 12 months. It often takes more than a year to improve one full turn. Set a goal of half or three quarters for that first 12 months. A great deal will depend on your ability to convert these captured assets into cash. Liquidation of inventory is a separate subject of discussion.

I will freely admit that there are additional methods of improving turns. Consider these methods the low-hanging fruit. This analysis will yield the largest group of captive dollars. Once you feel like you have exhausted these first two areas, give me a call. I will be happy to introduce you to some advanced digging tools. Good luck.

Jason Bader is managing partner of The Distribution Team, which specializes in helping distributors become more profitable through operating efficiencies. For more information, call (503) 282-2333 or contact him by e-mail at [email protected] Also visit www.thedistributionteam.com.

This article originally appeared in the July/August 2011 issue of Industrial Supply magazine. Copyright 2011, Direct Business Media.

What does it mean to be World Class related to Inventory Turns?

In the past I have always strived for a percentage improvement over the prior year or prior rolling three years. It's difficult to determine how much improvement is good enough other than ones own past experience. Does anyone know of any publications or other resources that I can reference to determine what manufacturing organizations experience and strive for regarding inventory turns (i.e. What does it mean to be World Class related to inventory turns?). Manufacturing category or sector specific would obviously be more useful to narrow the relevance of the information. Any advice or direction would be appreciated.

One place you can look for manufacturing or inventory management data on broad terms is APICS (www.apics.org) - the association for operations management. Your hard core materials management and planning types often have APICS certifications. Beyond that you can look to trade groups specific to your industry.

Inventory turns are one measure of appropriate investment strategy and operations execution - along with things like average days sales on hand, gross margin, lost sales analysis, and inventory cost reduction strategy.

Good question, Anonymous.

Check out this free report here on Proformative, with a good focus on how ERP can transform inventory management:

"Nucleus Research Report — The ROI of Cloud ERP for SMBs:"

Wouldn't the use of MRP or MRPII improve your turns by fine tuning inventory and purchasing to match forecasts & sales?

Thanks for the comments. While doing some additional research I was able to locate a nice resource that I thought I would share with the group. It is an annual publication that provides 50 performance indicators and covers 200 industries and 5.8 million US and International corporations. The title is "Almanac of Business and Industrial Financial Ratios" by Leo Troy, Ph.D. and is published by CCH (CCHGroup.com).

Company: Haygarth Consulting LLC

I would look at 2 versions:

1. historic inventory turns

2. projected inventory turns: today's inventory related to future sales (this helps determine if sales forecasting is also accurate and whether you need to take action now to change what will happen, rather than wait for historic measurement of what happen.

What also counts is the trend and whether you have taken any decisions to stockpile or liquidate inventories for other reasons, whether a product run out or launch is about to happen,

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